May 14, 2008

I love this quote from Louis Pasteur, "In the field of observation chance favours the prepared mind". I'm probably going to take this out of it's context, but I think the sentiment applies in many ways to trading and gambling.

I've been reading a fantastic book lately called "The Black Swan", by Nassim Taleb (links to be added later). A man rather a lot cleverer than I, with a clarity of thought on the subjects of randomness and prediction which is superior to most. I won't turn this into a book review, but I recommend everyone read it, the humour might not be to everyones taste, particularly the French, but it's extremely worthwhile.

Central to his theme is our inability to predict. Especially things which are extreme or unimaginable to us. It left me with a very healthy respect for randomness and much less respect for 'opinion'. I was a big fan of his previous book too, (link on the left side of the page half way down) "Fooled By Randomness". Taleb's background is in options trading, he specialised in setting up positions which exposed him to randomness well beyond the expectation of the market. The payoff for which was vastly beyond what anyone could imagine the probability of it's occurance was. Simply because it was unimaginable, the bets he was making were of fantastic value.

This was a new idea to me, a sort of 'exposure to randomness'. Getting the unexpected, 'onside', in a cheap or even free way, that would pay large dividends if these unexpected events ever occured. Conversly, the people trading in the opposite direction had no clue to the downside of their options and bets. These were people who focused on small, repeatable profits (read short odds) which crucially, were "expected" to happen. The lesson, never expect anything! Especially profits.

Back to the quote. He is not talking about taking your chances, or predicting your chances, or spotting a chance and predicting whether it will happen or not. It's about being exposed to chance in the right way. There is no expectation or prediction involved here. Prepare yourself / your position so that chance's happenings pay off with the most reward.

Taleb says, "you do not look for something particular every morning but work hard to let contingency enter your working life". This is wonderful advice.

On a practical level, I've been doing a lot of work on my trading to do with this. Specifically the realisation that I am reliant on the market to allow me out of a position, really I've not been giving enough priority to this... I hesitate to use the word respect in this instance, having read The Black Swan, I'm fairly convinced the market as a whole underestimates many unexpected things. What I am talking about is the fact that if I am to trade out of a position, then it is the market's position that allows me to do so, not me somehow bulldozing through it or willing it to get to a certain level before I can close.

How does this tie in ? Basically I am allowing market contingency to enter my trading. I'm exposed to the unexpected and thus, ultimately - panic and over-reaction. My reward is greater than it should be, the risk (downside) is minimal. These are the best trades you can have.

A lot of people use the term 'free lay', a bet with no downside and all upside should the unexpected happen. Taleb calls these, "free lottery tickets" and suggests we collect as many of these as we can. He's right you know.

Most of all, look for situations where the unexpected will hurt you, and ones where it will reward you. Minimise the former and expose yourself in as cheap a way possible to the later.